In many industries, equity compensation for management is the norm, not the exception, because it helps to align the incentives and interests of management and shareholders. Equity compensation can take many forms. Some of the more common include:
- Profit Interests or Carried Interests: interests in the future profits of partnerships. Entities treated as partnerships (such as LLCs) may issue “profit interests” to employees tax-free. Although Congress has repeatedly threatened to end the tax-free treatment of profits interests, none of this proposed legislation has yet been enacted.
- Restricted Stock Awards (RSAs) or Restricted Stock Units (RSUs): stock (or rights to stock) subject to vesting conditions. Upon vesting and receipt of the stock, the employee is subject to tax in an amount equal to the value of the stock.
- Phantom Equity: common among private companies, family-controlled companies, and other closely held companies, these are grants to employees that provide equivalent economic rights, without any actual stock ownership. It is important to ensure that these plans do not run afoul of Section 409A and other tax rules for deferred compensation.
- Stock Options (NSOs): rights to acquire stock at a set price (generally the value of the stock at the time of the grant). Employees are generally only taxable on stock options at the time of exercise in an amount equal to the spread between the strike price and fair market value.
- Incentive Stock Options (ISOs): stock options subject to a variety of restrictive conditions that entitle holders to better tax treatment, including tax-free exercise of the options.
- Confused about all the different choices for equity compensation and corresponding tax treatment? Jon can help advise on comparing different scenarios.